The financial metrics return on equity (ROE) and the return on capital employed (ROCE) are valuable tools for gauging a company's operational efficiency and the resulting potential for future growth in value. They are often used together to produce a more complete evaluation of financial performance.
Return on Equity
ROE is the percentage expression of a company's net income, as it is returned as value to shareholders. This formula allows investors and analysts an alternative measure of the company's profitability and calculates the efficiency with which a company generates profit, using the funds that shareholders have invested.
ROE is determined using the following equation:
Return on equity = Net income ÷ Shareholders' equity
In regard to this equation, net income is comprised of what is earned over the period of a year, minus all costs and expenses. It includes payouts made to preferred stockholders but not dividends paid to common stockholders (and the shareholders' overall equity value excludes preferred stock shares). In general, a higher ROE ratio means that the company is using its investors' money more efficiently to enhance corporate performance and allow it to grow and expand in order to generate increasing profits.
One recognized weakness of ROE as a performance measure lies in the fact that a disproportionate level of company debt results in smaller base amount of equity, thus producing a higher ROE value off even a very modest amount of net income. So, it is best to view ROE value in relation to other financial efficiency measures.
Return on Capital Employed
ROE evaluation is often combined with an assessment of the ROCE ratio. ROCE is calculated with the following formula:
ROCE = Earnings before interest and taxes (EBIT) ÷ Capital employed
ROE considers profits generated on shareholders' equity, but ROCE is the primary measure of how efficiently a company utilizes all available capital to generate additional profits. It can be more closely analyzed with ROE by substituting net income for EBIT in the calculation for ROCE.
ROCE works especially well when comparing the performance of companies in capital-intensive sectors, such as utilities and telecoms, because unlike other fundamentals, ROCE considers debt and other liabilities as well. This provides a better indication of financial performance for companies with significant debt.
To get a superior depiction of ROCE, adjustments may be needed. A company may occasionally cash on hand that isn't used in the business. As such, it may need to be subtracted from the Capital Employed figure to get a more accurate measure of ROCE.
The long-term ROCE is also an important indicator of performance. In general, investors tend to favor companies with stable and rising ROCE numbers over companies where ROCE is volatile year over year.